You should only pursue a digital nomad lifestyle if you’ve fully considered the tax consequences. We’ve already answered some of the most common tax questions taxpayers tend to have, but there’s one issue we wanted to explore in greater detail: how to source your income when you’re traveling.
What is Income Sourcing?
Income sourcing is the term we use to determine which jurisdiction(s) can claim your income for tax purposes.
When you earn income, it’s going to be taxed somewhere—you just need to determine where. And determining where to source your income is more nuanced than you might think. Income sourcing often depends on:
- Where you travel
- Where you stay when you take breaks from traveling
- Where you lived before you started traveling
- How much time you spend in each location
- Where you’ve filed tax returns previously
- The type of work you do
- What type of income you’re earning
- How your employer (if you have one) reports your earnings
Income sourcing is one of the most important things for you and your accountant to get right, because reporting earnings to the wrong jurisdiction could result surprise tax bills, interest, and hefty penalties.
Today, we wanted to talk about how to source active earnings (like wages and self-employment income), and we’ll save the discussion of how to source passive earnings (like dividends and interest) for another time.
American Digital Nomads Traveling in the US
Since the COVID-19 pandemic, there has been a seismic shift toward remote work. In fact, remote work grew by nearly 50% from 2019 to 2020. Some of these workers quit their jobs and started working for themselves, but many kept their corporate positions and simply started working remotely. Let’s talk about how to source your income in both scenarios.
In general, self-employed income is taxable to the state where the revenue is generated or where the work is performed. This means that if you are temporarily working in Georgia providing web design services for a client in Colorado, your earnings will most likely be sourced to Georgia, where you performed the work.
Does this mean digital nomads traveling around the US could owe taxes in more than one state?
If you do have significant liability in more than one state, you’ll not only need to file multiple state tax returns, but you may also be required to withhold quarterly estimated taxes in those states throughout the year.
Digital Nomads Employed by a US Corporation
In general, if you are employed, income should be sourced to the state where you perform your work duties regardless of your state residency status or where your employer is located. Although this is a great rule of thumb, there are a few things you should ask yourself first.
- What’s my state for payroll tax purposes?
Your employer reports wages and withholds state taxes on your behalf throughout the year when they file payroll tax returns. At the end of the year, you’ll see state income and withholding summarized on your W-2. Has your employer allocated your earnings to the correct states? If they haven’t, you may be subject to underpayment penalties in one state and have overpayments in another.
- How much information have I given my employer about my whereabouts?
If you don’t tell your employer that you’re traveling nomadically, they won’t know where to source your earnings. Talk to your employer about your travel-focused lifestyle and see what they want you to do. If they refuse to source your earnings to the correct state or if they employ a “don’t ask, don’t tell” policy, you may need to pay quarterly estimated taxes to those states to avoid a penalty.
- What does the tax code say?
If you change your tax domicile to a new state, you will owe taxes to that state no matter what. But if you’re simply visiting new states as nomadic traveler, you may not owe taxes right away. Some states (like Colorado) begin taxing nonresidents the first day they step foot across the border. Others (like Maine) will only tax nonresidents that surpass a days-worked or dollars-earned threshold.
- Are there reciprocal agreements in place?
If you travel nomadically, check to see which states have reciprocal agreements with your state of residency. If there is a reciprocal agreement in place, your employer can continue to withhold taxes in the state where you are domiciled rather than the state(s) where you temporarily work.
- Are there any exceptions?
Some states offer tax reprieves for certain workers (like military workers) or during times of hardships. For example, during the COVID-19 pandemic, some states exempted nonresidents’ earnings from tax if they worked from their state due to a work-from-home order.
Whether you are employed or self-employed, talk to a CPA who is well versed in multistate taxation before you begin traveling. They may have suggestions that can help you minimize your tax exposure and can provide tools to make tracking your earnings and paying quarterly taxes a bit easier.
American Digital Nomads Traveling Internationally
If you are an American citizen and you travel internationally, the IRS will tax 100% of your earnings, even if you spend most or all your time outside of the country.
You may also owe taxes to one or more foreign countries depending on where you travel.
Wait, isn’t that double taxation?
Yes, in a way. However, there are a few ways you can reduce your liability or avoid paying tax (legally!) in those foreign countries or here at home in the US.
- Tax Treaties
The Organisation for Economic Co-operation and Development (OECD) is an intergovernmental organization that seeks to reduce or eliminate double taxation by helping its member states adopt treaties that relieving taxpayers of filing responsibilities when they travel internationally. Check to see if the country you’re traveling to has adopted the OECD Model Tax Convention or has a different bilateral treaty with the US that protects workers from double taxation.
- IRS Tax Incentives
If you do end up paying taxes to a foreign country, you may be able to reduce your US tax liability. We go over a few of these tax incentives in our upcoming article.
- Digital Nomads Visas
Some countries exempt digital nomads from local taxes for a period of time if they are employed by a US corporation or if they provide services to customers in other countries. Just keep in mind that in most countries, you’ll incur a tax liability the moment you begin providing services to in-country residents.
What About State Taxes?
Federal-level taxes aren’t the only ones you need to worry about. Even if you’ve been traveling internationally for the entire year, you may be subject to state or local taxes here in the US. If a jurisdiction within the US considers you a resident, they will tax 100% of your earnings.
Before traveling internationally, some individuals try to change their tax domicile to a state that doesn’t assess and income tax, like Florida, Tennessee, or Texas. But this technique isn’t without its risks. Some states will work hard to classify international travelers as residents. The California Franchise Tax Board, for example, is notorious for taxing former residents of their state unless they have a strong case that they’ve changed residencies to another jurisdiction. Often, moving abroad is insufficient proof, and you may end up continuing to pay California taxes on income you earn while living abroad.
We discuss more about changing your state tax residency here, but the bottom line is that you may still be subject to state taxes even if you move abroad.
Are You a Digital Nomad?
Consider both the benefits and consequences of a nomadic lifestyle before you embark on such a journey. While the consequences may not be enough to deter you from traveling full-time, they may alter how you choose to travel. If you want to talk to a CPA well versed in domestic and international travel, reach out to us at AB FinWright.